A Short Straddle Option Strategy - Benefits Vs Unlimited Risk

Today I want to introduce you to an advanced options strategy we do not trade often at Options Master Trader. I am talking about Short Straddles which involve selling options.

Basically, you sell naked options of different types without purchasing any options. This creates a strategy that can turn out to be extremely profitable in the right market conditions, but this is counterbalanced by an unlimited potential loss which makes it expensive to trade and risky. You need to be able to read and sometimes anticipate market movements to make sure you sell options with high implied volatility which is about to decrease in value. If the opposite occurs and the implied volatility increases in value, you put yourself at serious risk.

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The VIX Index and High Volatility in the Market

That said at the end of May 2023 implied volatility was relatively high in the market compared to a previous period. I could spot that by looking at the chart of the VIX Index. I did not see any particular reasons why volatility would keep increasing and, in my opinion, it had reached a peak and would start declining in the short term. This could be a good time to initiate a strategy which involved selling high volatility and profit from its decline.

My goal was now to find an underlying security feasible for this kind of trade. After screening my watchlist on Interactive Brokers, I found what could be a good candidate in Home Depot (HD). The underlying was trading in a range between $280 and $303 and I expected implied volatility to decrease in the following days and weeks.

On Wednesday the 24th of May 2023, I decided to open a Short Straddle on HD by selling 2 contracts of the $290 put option strike price with expiration 21st July 2023 and simultaneously selling 2 contracts of the $290 call option strike price with expiration 21st July 2023. This created a beautiful risk profile like the one displayed in the video below which at first glance looks similar to the risk profile of a Calendar Spread. However, the similarities end on the risk graph as we are talking about two completely different strategies.

A Short Straddle Strategy Mechanics

The Short Straddle generated an entry credit/maximum profit of $4446 which could be achieved only if the underlying security was trading very close to the sold strike prices at expiration. The options sold had 58 days of remaining life meaning this was the maximum length of the trade if I did not decide to close it earlier.

Where it gets tricky is when we talk about the maximum loss. In fact, as you are selling naked options not backed by any purchased option this strategy can potentially bring to an unlimited loss. To trade the strategy, your broker will ask for a margin which is equal to the entry credit received. As your Short Straddle evolves this margin will decrease if the strategy goes into profit and will increase if the strategy starts losing money. The more your Short Straddle goes into losing territory, the more margin will be asked, and this makes this kind of trade extremely risky.

That is why I would not encourage beginners or less experienced traders to initiate a Short Straddle. And if you recall I started this article stating that at Options Master Trader, we do trade it only occasionally when we believe that the market conditions are just right. But the reality is that we can be wrong too and make mistakes.

Like a Long Straddle, a Short Straddle is a delta neutral trade with the main difference that in the former you purchase options premium and are looking for an increase in implied volatility and a substantial move of the stock, while in the latter you are an options premium seller and are looking for a decrease in implied volatility and little if no movement of the stock.

On this particular trade, I managed to make 35% profit in 44 days. This was due to the combined effect of the expected decline in implied volatility and the passage of time. To better understand the impact of these variables, let’s have a quick look at the Greeks. When I entered the trade, it was Vega negative (-$182.87) and Theta positive (+$37.78).

Vega negative indicates that a strategy benefits from a decline in implied volatility. On HD this meant that for every 1-point decline in the value of implied volatility, the Short Straddle would increase in value by $182.87. Conversely, a 1-point rise in the value of implied volatility would determine a $182.87 decrease in the value of the strategy. That is why it is key to understand the IV trend and behaviour before embarking in this kind of trade.

Theta positive indicates that a strategy benefits from time decay and you earn $37.78 each day just for the passage of time. This is as long as the underlying price is trading between the breakeven points by expiration.

Making an Adjustment to Reduce the Risk Exposure

On Monday the 5th of June 2023, after being 14 days into the trade I was making $700 in profit as the underlying security was trading in range and the IV dropping. With still 46 days remaining on the strategy, I decided to purchase back 1 contract of each option and halve the position to reduce the risk exposure, while still making some profit for effect of time decay and reduction in implied volatility.

If you watched the video, you could tell how from this point ahead the trade did not go quite as expected. HD started trading upwards and, at some point, almost touched the upside breakeven point with the strategy going slightly in losing territory. The trade was still under control, but it definitely was an unexpected scenario. This price movement was eating up the profits, plus triggered the request for more margins from the broker.

For this reason, on Friday the 7th of July 2023 with the stock declining from its high down to $302 and back in my profit area, I decided to offset the trade by purchasing back the remaining contracts for both put and call options. There were still 14 days left on the strategy, but I could not take any further risks.

The trade conditions had changed as HD was now trading in an uptrend. I closed the trade with a total profit of $1084 and a 35% ROI in 44 days. Despite the rise of the stock, it worked out pretty well in the end.

Hope you enjoyed this strategy!

I’ll see you in the next release of the options trading diary.